Inflation has peaked and the bear market has bottomed. That much seems clear. And yet, inflation is still elevated enough to shrink corporate profit margins.

A company’s profit margin is calculated by subtracting the cost of goods sold from total revenue and dividing that figure by total revenue. Multiply that figure by 100 to get a percentage.

Let’s take a closer look at “The Big Squeeze” on balance sheets, and why profit margins are actually on course to improve in 2023. As margins get better, so will the stock market’s prospects.

For Q4 2022, with 11% of S&P 500 companies reporting actual results, the blended earnings decline is -4.6%, according to FactSet. The blended revenue growth is 3.7%, the lowest since Q4 2020 (3.2%), as companies increasingly face difficulties in raising prices to offset higher costs.

“Blended” combines actual results for companies that have reported and estimated results for companies that have yet to report.

The blended net profit margin for the S&P 500 for Q4 2022 is 11.4%, which is below the previous quarter’s net profit margin of 11.9% and below the year-ago net profit margin of 12.4%.

We’ll know more about the future course of corporate operating results and the stock market, when we get the next reading of the personal consumption expenditures (PCE) index on Friday.

The PCE is the Federal Reserve’s preferred inflation gauge and the latest reading will greatly influence the Fed’s decision on rates next week. The analyst consensus is that year-over-year core PCE inflation will drop below 3% by June 2023.

WATCH THIS VIDEO: The Narrative Shifts from Inflation to Growth

If 11.4% turns out to be the actual net profit margin for Q4, it will represent the sixth consecutive quarter in which the net profit margin for the index has shrunk quarter-over-quarter. It will also represent the lowest net profit margin reported by the index since Q4 2020, when it came in at 10.9% (see chart).

Four sectors are reporting a year-over-year increase in their net profit margins in Q4 2022 compared to Q4 2021, led by energy (to 13.4% vs. 9.3%).

Seven sectors are reporting a year-over-year decline, led by materials (10.1% vs. 13.2%) and financials (15.5% vs. 18.5%).

In the case of financials, increased loan loss provisions are largely responsible. Higher interest rates are generating greater interest income for banks, but much of that gain is getting offset by bigger provisions for expected loan losses

Provisions for loan losses have no impact on revenue growth, but do affect bottom-line growth, because they are reported as an expense on a company’s income statement.

Four sectors are reporting net profit margins in Q4 2022 that are above their five-year averages, led by energy (13.4% vs. 7.4%). Seven sectors are reporting net profit margins in Q4 2022 that are below their five-year averages, led by communication services (9.6% vs. 11.7%).

Only two sectors are reporting a quarter-over-quarter increase in their Q4 net profit margins, led by financials (to 15.5% vs. 14.2%). Seven sectors are reporting a quarter-over-quarter decrease led by real estate (35.1% vs. 37.7%).

Communication services and information technology are reporting no change in net profit margins quarter-over-quarter.

Buckle up, Buttercup…

What’s fueling the continuing decline in net profit margins for the S&P 500? Higher costs. Inflation is cooling, but it’s still high. That said, as inflation continues what’s likely to be a downward slope, we’ll see profit margins improve this year. Friday’s PCE report will almost surely move markets.

Companies are facing a difficult year-over-year comparison to anomalously high net profit margins in 2021. In Q4 2021, the S&P 500 recorded the fourth-highest net profit margin (12.4%) reported by the index since FactSet began tracking this metric in 2008.

The main U.S. stock market indices closed mixed Wednesday, as weak corporate guidance rekindled recession fears. But stocks bounced back the next day in the wake of positive economic data, closing higher Thursday as follows:

• DJIA: +0.61%
• S&P 500: +1.10%
• NASDAQ: +1.76%
• Russell 2000: +0.67%

The Bureau of Labor Statistics reported Thursday that real U.S. gross domestic product (GDP) increased at an annual rate of 2.9% in Q4 2022, after climbing 3.2% in Q3.

The silver lining about Q4 operating results is that, although profit margins are indeed declining, they’re not collapsing. The latest U.S. GDP performance suggests that corporate profits will remain resilient.

In fact, margins are projected to soon resume an upward trajectory. As of this writing, the estimated net profit margins for Q1 2023, Q2 2023, Q3 2023, and Q4 2023 are 11.9%, 12.1%, 12.3%, and 12.2%, respectively.

Regardless, volatility is likely to persist at least over the short term, as investors await the Fed’s next decision at its meeting January 31-February 1. After the decision on rates is announced, our voluble Fed Chair, Jerome Powell, will hold a press conference. Buckle up.

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John Persinos is the editorial director of Investing Daily.

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